International Economics: Exchange Rate Determination

CHAPTER F I F T E E N
15 International
Economics
Tenth Edition
Exchange Rate Determination

Dominick Salvatore
John Wiley & Sons, Inc.
Presented by: Asoc. Prof. Dr. Nguyen Thuong Lang
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
Learning Goals:
 Understand the purchasing power parity
theory and why it does not work in the short
run
 Understand how the monetary and the
portfolio balance models of the exchange rate
work
 Understand the causes of exchange rate
overshooting
 Understand why exchange rates are so
difficult to forecast
Introduction
 Since floating rates began in 1973, international

financial flows are now larger than trade flows,
shifting the focus to monetary theories of
exchange rates.
 Monetary exchange rate theories view the
exchange rate as a purely financial phenomenon,
and tend to explain exchange rate volatility and
disequilibria in the short run.
Purchasing-Power Parity Theory
 Absolute Purchasing Power Parity

 The equilibrium exchange rate between two
currencies equals the ratio of price levels in both
nations.
R= P/P*
Where R = exchange rate or spot rate
P = general price level in home nation
P* = general price level in foreign nation
 Example: If the price of a bushel of wheat is $1 in the
United States and €1 in the European Monetary Union,
then the exchange rate between the dollar and the euro
should be R = $1/ €1 = 1.
 The law of one price

 A given commodity should have the same
price (so that the purchasing power of the two
currencies is at parity) in both countries when
expressed in terms of the same currency.
 Caused by commodity arbitrage.
 Absolute PPP theory can be misleading

because:
 Appears to give exchange rate that equilibrates
trade in goods and services while ignoring capital
account.
 At exchange rate that equilibrates trade in goods
and services, capital inflows would produce
surplus in balance of payments, while capital
outflows would lead to deficits.
 Absolute PPP theory can be misleading

because:
 Will not even give exchange rate that equilibrates
trade in goods and services because of existence of
nontraded goods.
 International trade tends to equalize prices of
traded goods and services, not nontraded goods.
 Relative Purchasing-Power Parity

 The change in the exchange rate over a period
of time should be proportional to the relative
change in the price levels of two nations over
the same time period.
P1 / P0
R1 = x R0
P*1 / P*0
where R1 and R0 = exchange rates in period 1 and base period
 Relative Purchasing-Power Parity

 Example: If the general price level does not change
in the foreign nation, from base period to period 1
(P*1/P*0 = 1), while the general price level in the
home nation increases 50%, the relative PPP theory
says the exchange rate should be 50% higher (home
currency should depreciate 50%) in period 1 as
compared to base period.
 Empirical Relevance
PPP Works PPP Works PPP Works

Well Less Well Not So Well
for highly traded for all traded goods for all goods
individual together (including nontraded
commodities goods).
over long periods of for one or two in the short run
time (many decades) decades
in cases of purely in periods of in situations of major
monetary disturbances monetary stability structural change
and inflationary
periods
Monetary Approach to the Balance of
Payments and Exchange Rates
 The monetary approach to the balance of

payments views the balance of payments as a
monetary phenomenon.
 Money plays crucial role in the long run as both a
disturbance and an adjustment.
 Under Fixed Exchange Rates

 A balance of payments surplus results from excess
stock of money demanded that is not satisfied by
domestic monetary authorities.
 A balance of payments deficit results from excess in
stock of money supplied that is not eliminated by
monetary authorities.
 Surplus/deficit is temporary and self-correcting in
the long run.
 Except for currency-reserve nation, the nation has
no control over its money supply in the long run
under fixed exchange system.
 Under Flexible Exchange Rates

 Balance of payments disequilibria are immediately
corrected by automatic changes in exchange rates
without international flow of money or reserves.
 Nation retains dominant control over its money
supply and monetary policy.
 Adjustment occurs as result of the change in
domestic prices accompanying the change in
exchange rate.
FIGURE 15-3 Relative Money Supplies and Exchange Rates.
 If PPP holds, P = RP*, and R =

 Money demand in each country can be
represented as
 In equilibrium, money supply must equal money
demand, yielding:
=
Portfolio Balance Model and Exchange Rates
 Portfolio Balance Approach

 The exchange rate is determined in the process of
equilibrating or balancing the stock or total
demand and supply of financial assets (of which
money is only one) in each country.
 Regarded as a more realistic and satisfactory
version of the monetary approach.
 Expectations, Interest Differentials, and

Exchange Rates
 The exchange rate is determined not only by the
relative growth of money supply and money
demand but also by inflation expectations and
expected changes.
 As long as domestic and foreign bonds are
assumed to be perfect substitutes, (i-i*) = EA,
where EA is the expected appreciation of the
foreign currency.

 If investors demand more of a foreign asset, either
because of higher relative foreign interest rates or
increased wealth, demand for foreign currency
will increase, depreciating domestic currency.
 If investors sell foreign assets, either because of
lower relative foreign interest rates or decreased
wealth, supply of foreign currency will increase,
appreciating domestic currency.

 Domestic and foreign bonds are assumed to be
imperfect substitutes; domestic investors require a
higher return to compensate for the risk of
holding foreign bonds.
 Stock model rather than a flow model.
 The exchange rate is determined in the process of
reaching equilibrium in each financial market.
 Extended Portfolio Balance Model

 From the uncovered interest parity condition,
(i-i*) =EA.
 Since domestic and foreign bonds are assumed to
be imperfect substitutes,
(i-i*) =EA – RP,
where RP is the risk premium on holding the foreign
bond.
 Extended Demand Functions

 (money demand)
 (domestic bond
demand)
 F (foreign bond
demand)
where Y is income, P is the price level, and W is
wealth.
 Extended Demand Functions

 M is a positive function of RP, Y, P, and W, and a
negative function of i, i*, and EA.
 D is a positive function of i, RP, and W, and a
negative function of i*, EA, Y, and P.
 F is a positive function of i*, EA, and W, and a
negative function of i, RP, Y, and P.
 Supplies of all assets are assumed to be
exogenous.
 Exchange rate changes are the result of portfolio
adjustment.
Exchange Rate Dynamics
 Exchange Rate Overshooting

 Stock adjustments in financial assets are usually
much larger and quicker to occur than
adjustments in trade flows.
 Most of the burden of adjustments in exchange
rates comes from financial markets in short run.
 Thus, exchange rate must overshoot or bypass its
long run equilibrium level for equilibrium to be
quickly reestablished in financial markets.
(Figure continues on next slide)
FIGURE 15-6 Exchange Rate Overshooting.
FIGURE 15-6 (continued)
Empirical Tests of the Monetary and Portfolio
Balance Models and Exchange Rate
Forecasting
 Models of exchange rates have not been very
successful at predicting future exchange rates.
 Reasons:
 Exchange rates are highly influenced by new
information.
 Expectations in exchange rate markets tend to be
self-fulfilling (at least in the short-run).
 This may lead to speculative bubbles, generate
movements in the market contrary to what is
expected by theory.
Case Study 15-1 Absolute Purchasing Power
Parity in the Real World
FIGURE 15-1 Actual and PPP Exchange Rate of the Dollar,

1973-2011.
Case Study 15-2 The Big Mac Index and the
Law of One Price
Case Study 15-2 The Big Mac Index and the
Law of One Price
Case Study 15-3 Relative Purchasing-Power
Parity in the Real World
FIGURE 15-2 Inflation Differentials and Exchange Rates, 1973-2011.

Case Study 15-4 Monetary Growth and
Inflation
Case Study 15-5 Nominal and Real Exchange
Rates, and the Monetary Approach
FIGURE 15-4 Nominal and Real Exchange Rate Indices Between the Dollar and
the Mark, 1973-2011.
Case Study 15-6 Interest Differentials,
Exchange Rates, and the Monetary Approach
FIGURE 15-5 Nominal Interest Rate Differentials and Exchange Rate Movements,
1973-2011.
Case Study 15-7 Exchange Rate Overshooting
of the U.S. Dollar
Case Study 15-8 The Euro Exchange Rate
Defies Forecasts
FIGURE 15-8 The Euro/Dollar Exchange Rate since the Introduction of the Euro.
Appendix: Formal Monetary Approach Model
where a is the price elasticity of demand for money,

b is the income elasticity of demand for money, c is
the interest elasticity of demand for money, and u is
the error term.

where m is the money multiplier, D is the domestic

component of the monetary base, and F is the
international component of the monetary base.
 Let D + F = H, for simplification.

 Setting money supply equal to money demand,
taking the logarithm of both sides, and
differentiating with respect to time yields
where g is the rate of growth.

 The weighted growth rate of the international
component of the nation’s monetary base is equal
to the negative weighted growth rate of the
domestic component, if all other growth rates are
zero.
 Thus, all other things equal, when the nation’s

monetary authorities change D, the reverse
change will automatically take place in F, when
exchange rates are fixed.
 Thus under fixed rates, monetary authorities
determine the composition but not the size of the
monetary base.
Appendix: Formal Portfolio Balance Model
and Exchange Rates
 Write the basic equations of the model as

M = a(i, i*)W
D = b(i, i*)W
RF = c(i, i*)W
W = M + D + RF
where M is the quantity demanded of money by
domestic residents, D is the demand for domestic
bonds, RF is the demand for foreign bonds, and W is
wealth.
and Exchange Rates
 The model assumes that the three portfolio

components represent a fixed proportion of
wealth.
 M is inversely related to both interest rates; D is
directly related to i and inversely related to i*; RF
is directly related to i* and inversely related to i.
 Increases in wealth increase the demand for all
assets.
and Exchange Rates
 Assuming that all three markets are in equilibrium

and solving for RF yields
RF = (1-a-b)W – f(i, i*)W
and
R = f(i,i*)W/F
 Thus the exchange rate is directly related to i* and
W and inversely related to I and F.

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CHAPTER F I F T E E N

Exchange Rate Determination

 Since floating rates began in 1973, international

 Absolute Purchasing Power Parity

 The law of one price

 Absolute PPP theory can be misleading

 Absolute PPP theory can be misleading

 Relative Purchasing-Power Parity

 Relative Purchasing-Power Parity

PPP Works PPP Works PPP Works

 The monetary approach to the balance of

 Under Fixed Exchange Rates

 Under Flexible Exchange Rates

 If PPP holds, P = RP*, and R =

 Portfolio Balance Approach

 Expectations, Interest Differentials, and

 Portfolio Balance Approach

 Portfolio Balance Approach

 Extended Portfolio Balance Model

 Extended Demand Functions

 Extended Demand Functions

 Exchange Rate Overshooting

FIGURE 15-6 Exchange Rate Overshooting.

FIGURE 15-1 Actual and PPP Exchange Rate of the Dollar,

FIGURE 15-2 Inflation Differentials and Exchange Rates, 1973-2011.

where a is the price elasticity of demand for money,

where m is the money multiplier, D is the domestic

 Let D + F = H, for simplification.

where g is the rate of growth.

 Thus, all other things equal, when the nation’s

 Write the basic equations of the model as

 The model assumes that the three portfolio

 Assuming that all three markets are in equilibrium

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